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Price elasticity
By the end of this chapter, you should be able to:
• define price elasticity of demand and supply and perform simple calculations
• demonstrate the usefulness of price elasticity in particular situations such as
revenue changes and consumer expenditure.
Taken from Cambridge International ExamiJlabom ~la bus (IGCSE 0455/0 Level 228 1)
O Camb<odgelntematiooalExaminatioo,
Price elasticity of demand
The law of demand (see Chapter 3) states that as the price ofa product increases, the
quantity demanded of that product will rend to full. H owever, the responsiveness of
change in the quamiry demanded may vary depending on the customer's degree of
ability and willingness to pay. For example, a rise in the price of a product with plemy
of substitutes (such as bananas, greetings cards or chocolate bars) will have a larger
impact on its lewl of demand than a rise in the price ofa product that has fewer
substitutes (such as petrol, roothpaste or haircuts).
Price elasticity of dema nd (PED) measures the degree of responsiveness of
quantity demanded for a product following a change in its price. !fa price change
causes a relatively small change in the quantity demanded, then demand is said to
be price inelaHic: that is, buyers are not highly responsive to changes in price. For
example, if the price of rice increases slightly, it is unlikely seriously to affect the
demand for rice in countries like China, Vietnam and Thailand.
By contrast, demand is said to be price elastic if there is a relath·ely large change
in the quantity demanded of a product following a change in its price: that is, buyers
are very responsive to changes in price. For example, a small rise in the price of Pepsi
Cola is likely to reduce its demand quite drastically as customers switch to buying
rival brands such as Coca-Cola.
Demandforsoftdrinksispriceelasticbecausethereare
many substitute products
Asastaplefoodforbillionsofpeople, ricei shighlyprice
inelasticinAsiaandtheWestlndies
Price elasticity
Exam p ractice
Explain whether the price elasticity of demand for the following products is likely to
be price elastic or price inelastic. Justify your answers.
1 Pineapples
2 To~
(4)
3 Overseas holidays
4 Textbooks
(4)
(4)
~
The uses of price elasticity of demand
Knowledge of PED can give firms valuable information about how demand for their
products is likely to change if prices are adjusted. This information can be used in
se\·eralways:
• Helping firms to decide on
their pricing strategy - for
example, a business with price
inelastic demand for its
products is likely to increase
its prices, knowing that
quantity demanded will be
hardly affected. Therefore, the
firm will benefit from higher
revenue from selling its
products at a higher price.
• Predicting the impact on
firms following changes in the
exchange rate - for instance,
firms that rely on exports will Theme parks charge different prices for essentially the
same service. The difference is explained by PED
generally benefit from lower
exchange rates (as the price
of exports become cheaper) and thus will become more price competitive. l11is
assumes that the PED for exports is elastic, of course.
• Price discrimination - this occurs when firms charge different customers different
prices for essentially the same product because of differences in their PED. For
example, theme parks charge adults different prices from children and they also
offer discounts for families and annual pass holders.
• Deciding how much ofa sales tax can be passed on to customers - for example,
products sud1 as alcohol, tobacco and petrol are price inelastic in demand, so
government taxes on these products can quite easily be passed on to customers
without much impact on the quantity demanded.
• Helping governments to determine taxation policies - for example, the
government can impose heavy taxes on demerit goods (see Chapter 5) such
as petrol and cigarettes, knowing that the demand for these products is price
inelastic. While demerit goods are harmful to society as a whole, the high level
ofraxes on such products does not significantly affect the level of demand (with
minimal impact on sales revenues and jobs), but the go\·ernment can collect large
sumsoftax revenues.
The a/location of resources: how the market works; market failure
Activity
Discuss in pairs some examples of the ways in which multinational companies such as
McDonald's, Microsoft, IKEA and Audi use PED in their businesses.
Calculating price elasticity of demand
Price elasticity of demand is calculated using the formula:
PED
percentage change in quantity demanded
percentage change in price
which can be abbreviated as:
PED =%b.QD
"p
For example, ifa cinema increases its ticket price from $10 to $11 and this leads to
demand fulling from 3500 to 3325 customers per week, then the PED for cinema
tickets is calculated as:
332
500
• percentage change in quantity demanded=
x 100 = - 5%
: - ~
50
11 10
• percentage change in price = ;
x 100 = + 10%
0
• PED = ~
10
=-0.5
Worked example: Calculating PED
Assumethedemandforfootball
matchticketsatSSOisSOOOO
perweek. lfthefootballclub
raisesitspricetoS60perticket
and demand subsequently
fallsto45000perweek,what
isthevalueofpriceelasticity
of demand?
• First,calculatethe
percentage change in
thequantitydemanded demandfellby10percent
from50000to45000match
tickets per week.
• Next,calculatethe
percentage change in the
priceofmatchtickets pricesincreasedby20per
centfromSSOtoS60per
match ticket.
• Then, substitutethesefiguresintothePEDformula:
~
20
m- 0.5
As the PED for match tickets is less than 1 (ignoring the minus sign), the demand for match
tickets is price inelastic: in other words, football fans are not very responsive to the increase
inmatchticketprices. Consequently,thereisarelativelysmallfallinthequantitydemanded
comparedwiththepricerise.
Price elasticity
Interpreting PED calculations
So what does a PED value of -0.5 actually mean? The cinema ticker example suggests
that the demand for cinema tickers is price inelastic (i.e. relatively unresponsive to
changes in price). This is because a 10 per cent increase in the price (from $10 to $11)
only caused quantity demanded to drop by 5 per cent (from 3500 tickers per week
to3325 ).
The value of PED is negative due to the law of demand - an increase in the
price of a product will rend to reduce its quantity demanded (see Chapter 3). The
inverse relationship between price and quantity demanded also applies in the case
of a price reduction - rhar is, a price fall rends to lead to an increase in the quantity
demanded.
The calculation of PED generally has rwo possible outcomes:
• If the PED for a product is less than l (ignoring the minus sign), then demand
is price inelastic (i.e. demand is relatively unresponsive to changes in price).
This is because the percentage change in quantity demanded is smaller than the
percentage change in the price (see Figure 4.1).
• If the PED for a product is greater than 1 (ignoring the minus sign), then demand
is price elastic (i.e. demand is relatively responsive to changes in price). This is
because the percentage change in quantity demanded is larger than the percentage
change in the price of the product (see Figure 4.2).
§;
p~lLti~~t~
i i P1
0
;:i~~ : n,!~"'ceeci
~~~~;i:1~:~
G)., QI
Gm nti!ydernooded
Figure4.1
Thepriceinelasticdemandcurve
. j''E f:cr~~:;::;a:
=:~Jm~ta•"'ci
]
p~
chocda1ebcn, .drdmls.
mu and ai rline travel
0
QI
Gi
Gm nti!y demaoded
Figure4.2 Thepriceelasticdemandcurve
The a/location of resources: how the market works; market failure
However, there are three special cases which are theoretical possibilities:
• If the PED for a product is equal to 0, then demand is perfectly price inelastic:
that is, a change in price has no impact on the quamity demanded. This suggests
that there is absolutely no substitute for such a product, so suppliers can charge
whatever price they like (see Figure 4.3).
• If the PED for a product is equal to infinity ("") then demand is perfectly price
elastic: that is, a change in price leads to zero quantity demanded. This suggests
that customers switch to buying other substitute products if suppliers raise their
price (see Figure 4.4).
• If the PED for a product is equal to l (ignoring the minus sign), then demand has
unitar}' price elasticity: that is, the percentage change in the quamity demanded
is proportional to the change in the price (see Figure 4.5 ).
~(~
r r__~~i~:f"
1
~~1t~1ceevel.
P,
~~~"'t~
'"'"""
a.
0
Qoor111ydemanded
Figure4.3 Theperfectlypriceinelasticdemandcurve
C
i[j~~
§op
0
]
0
~~,:~nex~a~~
kocislo oo lnfini1echan'1hln
~i:"~1:=i1t+:re
~:1::'~'"ti= ~ify
Gloo ntifydemaoded
Figure4.4 Theperfectlypriceelasticdemandcurve
o
Qi
E~~'i"~
a,
~nded
Figure4.5 Theunitarypriceelasticdemandcurve
Price elasticity
Ac t ivity
Many governments around the world raise taxes on tobacco, alcohol and petrol, on a
regular basis.
1 Asaclass,discu5Stheeconomicreasonsfordoingso.
2 Usetheconceptofpriceelasticityofdemandinyourarguments.
Exam practice
1 Assume the price of a sack of rice falls from $25 to $24, resulting in an increase in
quantity demanded from 850 sacks to 875 sacks per month. Calculate the value
of price elasticity of demand for the product and comment on your fi nding.
(4)
2 Explain two reasons why the demand for rice is price inelastic in countries like
India, Vietnam and China.
(4)
Determinants o f price elasticity of dema nd
There are many interlinked determinants of the PED for a product:
Demand for fresh
flowers on special
days like Valentine's
Day and Mother's
Day is relatively price
inelastic compared
with other days
• Su bstitutio n - This is the key determinant of the PED for a good or service. In
general, the greater the number and availability of close substitutes there are for
a good or service, the higher the value of its PED will tend to be. This is because
such products are easily replaced if the price increases, due to the large number
of close substitutes that are readily available. By contrast, products with few
substitutes, such as toathpicks, private education and prescribed medicines, have
relatively price inelastic demand.
• Income - The proportion of a consumer's income that is spent on a product also
affects the value of its PED. lf the price of a box ofroothpicks or a packet of salt
were to double, the percentage change in price is so insignificam to the consumer's
overall income that quantity demanded would be hardly affected, if at all.
By contrast, if the price of an overseas cruise holiday were to rise by 25 per cent
from $10000 to $12 500 per person, this would discourage many more customers
because the extra $2500 per ticket has a larger impact on a person's disposable
income (even though the percentage increase in the price ofa cruise holiday is
much lower than that of the box of toothpicks or packet of salt).
Therefore, the larger the proportion ofincome that the price of a product
represents, the greater the value of its PED tends to be. Of course, those on
extremely high levels of income (such as Carlos Slim, Bill Gates and Warren
Buffet - the three richest men on the planet) are probably not responsive to any
change in the market price of goods and services!
• Necessity - The degree of necessity of a good or service will affect the value of its
PED. Products that are regarded as essential (such as food, fuel, medicines, housing
and transportation) tend to be relath'ely price inelastic because households need these
goods and services, and so will continue to purchase them even if their prices rise.
By contrast, the demand for luxury products (such as Gucci suits, Chanel handbags
and Omega watches) is price elastic, as these are not necessities for most households.
The degree of necessity also depends on the timeframe in question. For example,
demand for fresh flowers on Valentine's Day and on Mother's Day is relatively price
inelastic compared with other days. It also applies to peak and off-peak times. For
example , many countries operate public transport systems that charge more for
The a/location of resources: how the market works; market failure
•
•
•
•
•
Study tips
Although
there are many
determinants
ofP ED,thekey
factors can be
remembered by
THIS acronym:
• Time
• Habits,
addictions and
• Income
• Substitutes
(ava ila bi lity
and price of).
•
tra\'Clling during peak time. This is partly due to overcrowding problems during
such times, but also because the transport operators know that peak·time travel is
more of a necessity than off-peak travel.
H abits, add ictio n s, fashio n and t astes - !fa product is habit forming (such as
tobacco) or highly fashionable (such as smartphones in many coumries), its PED
tends to be relatively price inelastic. Similarly, people who are extremely devoted to
a particular hobby, such as sports or music, are more willing to pay, e\·en at higher
prices. Hence, the demand from these people is less sensitive to changes in price.
Ad vertising an d brand loyalty - Marketing can have a huge impact on the buying
habits of customers. Effectiw advertising campaigns for certain products nor only
help to shift the demand curve outwards to the right, but can also reduce the
price elasticity of demand for the product. Customers who are loyal to particular
brands are less sensitive to a change in their prices, partly because these brands are
demanded our of habit and personal preference - rhar is, they are the default choice
over rival brands. Examples of brands with a loyal customer following include
Coca-Cola, Apple, Samsung, Chanel, Toyota and Mercedes-Benz.
Time - The period of time under consideration can affect the value of PED
because people need time to change their habits and behavioural norms. Over
time, they can adjust their demand in response to more permanent price changes
by seeking out alternath·e products. For example, parems with children in private
fee -paying schools are unlikely to withdraw their children from school if these
establishments raise school fees because this would be very disruptive to their
children's learning. Similarly, owners ofprivare motor \·chicles are nor likely to
get rid ofrheir vehicles simply because of higher fuel prices. H owever, if there is
a continual hike in prices o\·er time, both parents and vehicle owners may seek
alternarh·es. H ence, demand rends to be more price elastic in the long run.
D u rab ility - Some products, such as fresh milk, are perishable (do nor last \'cry
Jong) and need to be replaced, so will continue to be bought even if prices rise.
By contrast, if the price of consumer durable products (such as household furniture,
LCD televisions or motor vehicles) increases, then households may decide to posq:one
replacing these items due to the high prices involved in such purchases. Therefore, the
more durable a product is, the more price elastic its demand tends to be.
T he costs o f switching - There may be costs inrnh'ed for customers who wish
to switch benveen brands or products. In the case of high switching costs, the
demand for the product is Jess sensitive to changes in price - rhar is, it tends to be
price inelastic.
For example, manufacturers ofsmartphones, laptops and digital cameras
make it more difficult for their customers to switch between rival brands by
supplying different power chargers, memory cards and software. Similarly,
mobile phone users and satellite television subsc.ribers are bound by length}'
contracts, which makes switching between rival brands or services less easy.
Such barriers to switching therefore make customers less responsi\·e to higher
product prices.
T h e br ead th of definition o f th e prod uct - !fa good or service is very broadly
defined (such as 'food' rather than fruit, meat, apples or salmon), then demand
will be more price inelastic. For example, there is clearly no real substitute for
food or housing, so demand for these products will be very price inelastic.
H owever, it is perhaps more useful to measure the price elasticity of demand for
specific brands or products, such as carbonated soft drinks, Australian beef and
!GCSE textbooks.
Price elasticity
Case Study: Toyota Motor Corporatio n
Japanesecar-makerToyotahasseen its
fairshareoftroublesinrecenttimes. It
hashadtodealwithseveralcasesof
global productrecallsforitscarsdueto
safety concerns. The global financial crisis
of2008alsoharmedglobalsalesfor
severalyears. Ontopofthat,muchofthe
world's largest car-maker's stocks of new
carsweredestroyedinthetsunamiof
March 2011 .
Nevertheless,customerloyaltyremains
strong in the USA, China and many other
parts of the world. Toyota's closest rival,
General Moto rs (GM), estimated the value of customer loyalty at S700 million for every
percentage point of improvement in customer retention rates.
Market research from Experian Automotive revealed that 47.3 per cent of Toyota's
current customers from the USA would purchase a Toyota, Scion or Lex us model as their
nextcar. Globally,thisfigurestandsat58percentforToyotaand52percentforGM.
Toyota'suseofmarketingsloganssuchas'Thebestbuiltcarsintheworld'cancertainly
go a long way to reassure Toyota's loyal customers about their cars.
SourcPS:adaptl'dfromW.JI/Sm>etJouma/andT/Mf8u5ines,
Discusshowtheconceptofpriceelasticityofdemandanditsdeterminantscanhelpto
explain why Toyota Motor Corporation is the world's largest car-maker.
PED, consumer expenditure and revenue changes
Knowledge of the price elasticity of demand for a product can be used to assess the
impact on consumer expenditure and therefore sales revenue following changes in
price. Sales revenue is the amoum of money received by a supplier from the sale ofa
good or service. It is calculated by multiplying the price charged for each product by
the quamitysold, i.e.
Rc~·enue = price x quantity demanded
Note that this is not the same as profit, which is the numerical difference between a
firm's sales revenues and its total costs of production.
For example, if Leno.•o sells 5000 laptops at $700 each in the first quarter of the
month, its sales revenue is $3.5 million. Suppose that the computer maker reduces its
price to $650 and quantity demanded rises to 5200 units in the following quarter.
Was this a gcxxi business decision?
The a/location of resources: how the market works; market failure
A quick calculation of PED reveals that the demand fur Lenom laptops is price elastic:
550
~~000 x l 00 = +10%
• percenrage change in quantity demanded=
• percenrage change in price= $
65
7
~; ~ 00 x 100 = - 7. 14%
0
• thus, PED= 1.4
This means the PED fur Lenovo laptops is price elastic. Hence a fall in price causes a
relatively larger increase in the quantity demanded, so sales revenues should increase.
This can be checked as follows:
original sales revenue = $700 x 5000: $3 500000
new sales revenue = $650 x 5500 = $3 575 OOO
difference in sales revenue= $3.575m - $3.5m = +75000
Given that demand fur LenO\'O laptops in the above example is price elastic, a reduction
in price was a sensible business decision. Therefore , it can be seen that knowledge of PED
fur a product can infurm firms about their pricing strategy in order to maximise sales
revenues. These relationships are summarised in Table 4. 1 and and Figures 4.6 and 4.7.
Ta ble4.1
TherelationshipbetweenPEDandsalesrevenue
Price chan ge
Inel a sti c
Increase price
Reduce price
Figure4.6
Revenues fall
Unita ry
Elas ti c
No change in revenues
Revenues fall
No change in revenues
Price inelasticdemandandsalesrevenue
=~~tj.!.,vfu
p
resporu;M!1ochange, ln ~el . A
1
:~r.:~:~,*:=C:.&f
~ j p~
1oa
contra.ll. lfp<tewera1olocreose
de
:=.-;:~~:::
ne! b. ln><Jle:sreveo.ie
Q
QI
G:i
Qw~
Figure4.7
Priceelasticdemandandsales revenue
Price elasticity
Activity
In small groups, discuss why firms use peak and off-peak pricing strategies, such as airline
ticketsbeingfarmoreexpensiveduringschoolholidays.
1 How many examples of price discrimination based on time (peak and off-peak) can your
group come up with?
2 Does your group believe that price discrimination is beneficial? Justify your argument.
Exam practice
Suppose Sharma Fabrics sells 1350 units of wool per month at $4.00 each. Following
an increase in price to $4.60 per unit, the firm discovers that the quantity demanded
falls to 1215unitspermonth.
1
2
Calculate the price elasticity of demand for wool sold at Sharma Fabrics.
Calculate the change in the total revenue following the increase in price of
wool.
l
Explain how knowledge of price elasticity of demand can be of use to Sharma
Fabrics.
(3)
(3)
[4)
Price elasticity of supply
Price elasticity of supply (PES) measures the responsh'Cness of the quantity supplied
ofa product following a change in its price. Supply is said to be price elastic if
producers can quite easily increase supply without a time delay if there is an increase
in the price of the product. This can help to gi\'c such finns a compctiti\'c advantage,
as they arc able to respond to changes in price.
By contrast, supply is price inelastic if firms find it difficult to change production
in a gi\'cn time period when the market price d1angcs.
Calculating price elasticity of supply
Price elasticity of supply is calculated using the formula:
percentage change in quantity supplied
PES
percentage change in price
whid1 can be abbreviated as:
%t.QS
PES = %K]>
For example, if the market price of beans increased from $2 per kilo to $2.20 per
kilo, causing quantity supplied to rise from 10000 units to 10 500 units, then the
PES is calculated as:
• percentage change in quantity supplied=
105
~~~000 x lOO = +5%
2
2
• percentage change in price= $ .2~ ~ $ .0 x 100 = +1 0%
20
• PES=~=0.5
+10%
CD